What should pensionable employees who leave their job before normal retirement age (NRA) do with their pension at their former employer? Should they roll the pension over into a self-directed retirement account like an IRA? Or, should they wait until NRA and collect the annuity?

These are simple enough questions, but not ones I ever had to deal with personally since my pension never accrued a value while I worked. That said, there are ways to determine the answers to these questions. But, as with many things connected to pensions, such as the Golden Albatross inflection point, it often involves a mix of math and emotion. It certainly did for one reader who had a pension roll-over question, so I made it the topic of this Pension Couch post.

For those that don’t remember, Pension Couch articles are created from lightly edited and sanitized email/message exchanges in which I answer readers’ pension questions. Names and some details have been sanitized to protect the innocent. Also, don’t forget that I speak in general about pensions throughout this post because every pension plan is different. So, make sure you research your specific plan before taking any action!

Goodbye, Military Pension …

As both a retired US military member and blogger of pensions, I often remind myself that most defined benefit pension (DBP) plans function differently than mine. This is especially true during the working years since most civilian pensions accrue value. That value is typically accrued through a combination of employee and employer contributions and pension fund investment returns.

In contrast, the US military pension system doesn’t require employee contributions. Nor does a military pension accrue any value that a military member can take with them if they leave before vesting. While behind the scenes, the US government expends great effort to create the necessary amount to fund a military retiree’s pension to the retiring military member. However, for a retiring member, the pension simply manifests as promised upon retirement.

Of course, the downside of the military system is that if the service member leaves the military before meeting the minimum vesting period of 20 years of service (YOS), they depart without a pension. For example, there are no accumulated assets for 12 YOS that a departing military member can roll over. At best, a non-vested ex-servicemember may be able to “buy back” years in their new employer’s DBP plan, assuming the employer has one. I describe this system in Pension Series Part 17 for those interested.

… Hello Civilian Pension

On the other hand, departing with partial value accrued in a pension is possible for many pensionable civilian jobs in the US, both in the public or private sector. The primary reason for that is most pensionable workers must contribute to their pension funds. And, for the most part, departing employees who’ve yet to reach retirement age can take their contributed funds with them when they leave. Furthermore, if a departing employee is vested, then in many cases, they can also take some percentage of the accumulated interest earned on those contributions with them. By taking it with them, I mean roll the pension’s value over to some sort of savings account, be that tax-advantaged or otherwise.

That said, it’s a rare day when the value of a civilian’s defined benefit pension (DBP) in the US can be transferred from one pension system to another. As I’ve often written about in the Pension Series, the reason for this is that every US DBP plan is different. Some of those differences are slight, while others are quite large. However, the effect is the same; many (maybe even most) US DBPs are not transferable or portable.

This stands in stark contrast to defined contribution retirement accounts, like 401(k)s. Their values can often be transferred from one employer’s plan to another. Thus, the only way to make a US DBP’s value as portable as a 401(k) is to extract it as a lump sum and roll it over to a personal retirement savings account, like an Individual Retirement Account (IRA). That’s assuming the entire value can be extracted in that manner, which again varies from pension plan to pension plan.

It’s Good to Have Options, Right?

Of course, a departing vested worker doesn’t have to lump-sum and roll over their pension if they leave before the plan’s normal retirement age (NRA). In most cases, departing employees can leave their pension in their former employer’s plan and collect pension payments (i.e., the annuity) once they reach the NRA. Their pension payments wouldn’t be as big as if they had otherwise stayed. However, they could collect annuity payments nonetheless.

That said, in many pension plans, the pension values for non-retired former employees do not accrue interest or investment returns. Depending on the plan, left-behind pensions may not even accrue value to mitigate inflation. This means that the value of the left-behind pension would lessen over time as inflation worked its pernicious effect.

On the other hand, the promised safety of fixed-income in retirement appeals to many former pensionable workers. It’s also cheaper than buying an insurance annuity. As a result, these former employees must often decide whether or not they should leave the pension or roll it over.

Sleepless In Big Apple

This is the situation that a reader (whom I’ll call Sleepless) found themselves in towards the end of 2020 and the start of 2021. Sleepless had left his/her pensionable job as a state employee in the Northeastern US for the lure of more meaningful work at a non-government organization (NGO) in the Big Apple. While the new job also had a defined benefit pension plan, the two systems were incompatible. This presented Sleepless with a problem, one which he/she describes below:

I had a pension that I vested in before leaving. It stopped accruing the [annual] 5% interest that it had been accruing for the 7 years since I left and was rolled over into a non-interest-bearing account. If I leave it in, I can draw roughly $400 a month starting at 55 with a beneficiary option of $370/mo should anything happen. Should I roll this amount into a traditional IRA or keep it for the monthly pension payout? If I roll it out but decide to return to this system, I can always buy back into it. I’d have to pay back the rolled-over amount with interest for every year I was gone. Any suggestions or experiences with this to consider?

GM Response #1

While the above paragraph may seem like an excellent run-down of Sleepless’s former pension situation, it lacked essential elements like age, family/financial situation, and retirement budget needs. As a result, I could only provide Sleepless with some principles about lump-sum vs. annuity decisions that I had run across during my master’s thesis research. I cut and pasted my response below:

Sleepless,

Good questions, but without more data, I can only give you generalities from what economists would tell you. In general, the few times it makes mathematical sense to take the lump-sum (based on something called the Annuity Puzzle) are:

1) When you’re young(ish), partly because of the ‘time value of money (i.e., cash in hand now is more valuable than cash in hand later), but mainly because … see #2

2) Inflation. If your pension value isn’t inflation-protected, and you’re young(ish), with a good bit of time until the annuity would start, then inflation will eat away at its purchasing power. So, if your pension doesn’t have a COLA (which fights inflation), then the mathematically correct action is to roll it over into a tax-advantaged retirement account like an IRA or Roth. But only a Roth if your taxes can handle the sum of money showing up as regular income.

3) The sum is small. In fact, US federal law allows pension plans to automatically lump sum and roll over pensions with present values under $5000.

4) Safety and/or heirs. Behavioral economists have concluded that people almost always take the lump sum if they don’t trust that the pension will be there as promised (i.e., the pension trust fund is underfunded). People also almost always take it if they intend to leave the money to heirs.

Conversely, if a person does not check one or two of the boxes above, they are probably better off taking the annuity.

That said, lump-sums are a fascinating subject. If you want to read up on the wonkiness of the Annuity Puzzle, try this article by a few super-smart behavioral economists that actually can write in terms that people understand. It’s about the most accessible academic article that you’ll find on the topic: https://www.aeaweb.org/articles?id=10.1257/jep.25.4.143

Round 2

Now, most readers at this point would have ghosted me (see my first pension couch article as to why). A smaller number would’ve simply thanked me for my time. However, as you’re about to find out, Sleepless is more well-mannered than most and REALLY wanted an answer to his/her question. Here’s what Sleepless said in response to my initial reply:

Thanks for the thorough response to my question! I hope you can guide me with more information on my pension question. The pension that stopped accruing interest is roughly worth $18,464. At 55 years of age, I can draw $403 per month, and if anything happens to me after filing for retirement, my spouse can draw $370 a month. Alternatively, I can name one of the kids, and they can get $339 a month. It does have a small COLA adjustment. I’m 38, and my spouse is 43.

If I roll it over, I can always come back to this tier since I left after vesting. I’d have to buy back the time, which is the amount I rolled out with some fees, and pay 5% interest for every year that I was out of the system. It sounds steep to pay back but maybe doable, especially if we want to retire earlier than 55. What do you advise?

GM’s Round #2 Response

That’s me, thorough to a T.

I now had enough information to analyze Sleepless’ questions in-depth. So, I wrote another thorough response back to Sleepless, which I cut and pasted below. Just keep in mind that I wrote it long before the COVID-caused disruptions to international supply chains seriously increased inflation in the latter half of 2021. Thus, my use of a much lower inflation figure in his/her scenario!

Sleepless,

I’m more than happy to help you figure some options out, but please understand that I’m not advising you on what to do. I’m simply diagnosing your pension situation.

The first thing I would say is that now that I know your age, I can assess the impact of inflation much better. I’m assuming that the pension total you provided ($18,464) and the monthly payment of the annuity ($403) are now static, meaning the COLA doesn’t kick in until the payments start. That means there are 17 years before payments start for inflation to eat away at your purchasing power.

If you go to Buyupside.com’s inflation calculator and punch in $18,464 in the “Today’s Amount” box, 17 years into the “number of years” box, and 2 into the “annual inflation %” box, you’ll get $13,186.30 as the “reduced amount.” What that tells you is that in 17 years, if inflation holds at 2%, your $18,464 would only be able to buy $13,186.30 of goods in today’s dollars.

Another way to look at it, which the calculator also gives you, is that you would need $25,854.06 17 years from now to purchase the same amount of goods that $18,464 buys you today. Run that with the monthly $403 annuity payment, and you get $287.81 in today’s purchasing power. Or, alternatively, you would need $564.30 17 years from now just to purchase the same amount of goods that $403 buys you today.

Either way you look at it, and again assuming that your current pension total won’t change, it means your pension will drop about 30% in value between today and when you start collecting.

On the other hand, let’s say you roll the $18,464 over into an IRA (which assumes your lump sum total is $18,464 and that your pension system allows you to roll over the money into an IRA) and invest it in an index fund that tracks the S&P 500 for 17 years. The S&P 500 returns about 10% a year on average, but after inflation and what I like to call the ‘human factor,’ let’s say the real return is something closer to 6%, just to be conservative.

If you go to Buyupside.com’s Future Value calculator and punch those numbers in, you’ll see that in 17 years, you could grow your money to somewhere around $42,319.83. Now that assumes a consistent return, and stock markets are anything but consistent year to year. However, you have a high probability of growing your money’s purchasing power over the long run. You might even double it instead of letting it wilt away due to inflation. So, in my opinion, assuming my assumptions are correct, the math speaks for itself.

Of course, math is one thing, but human psychology is another. You need to realize that by eliminating interest accruals on your pension amount, the pension fund is trying to incentivize you to roll that money over to a personal account like an IRA. It’s a way for them to clear their balance sheets of future obligations, which are risky and unpredictable. Plus, the 5% interest payment you would need to pay on top of the $18K to buy back into the pension fund, should you return, probably represents a better return on the money than the pension fund could make. So, in actuality, you rolling the money over is a win-win as far as the pension trust fund is concerned.

Speaking of returning to that pension system, you’ve stated several times that you might return to that job. I don’t know why you left, nor would I presume why you would go back. However, if you think there is a chance that you might return and buy back into the pension system, then the math gets a lot more complicated. So do the tax implications, for that matter.

In my opinion, it sounds like you need to determine the likelihood of returning before deciding what to do with the money. Taking a year or two to see where the dust settles before doing something with the $18K won’t kill you. That said, once inertia takes hold, it gets harder and harder to make a move with your money. If you decide to delay the decision, I would definitely write down a plan to check up on your decision every 6 months and create a hard deadline within 12 – 24 months to make a final decision.

Finally, we haven’t even talked about the pension fund safety factor. If you don’t mind me asking, what pension system is this money a part of? If it’s somewhere like Illinois, where state pensions face severe funding shortages, that too would indicate what you ought to do with the money. Hope this helps!

(It turned out that the former pension was in a well-run state system, so safety wasn’t an issue!)

Round 3: A Synopsis on Post-Pandemic Life

At this point in the article, I will synopsize several months of Facebook and email conversations into a few paragraphs. I’m doing that because, over those months, the nature of Sleepless’ query changed … multiple times. In the end, though, the initial question that Sleepless asked was the only one I could really help him/her answer. Thus, while it made for a wild but exciting conversation across several electronic mediums, a lot of it just isn’t pertinent to the topic of this post.

That said, it turns out that Sleepless experienced what many workers went through between 2020 and 2021 due to COVID-19. This included: an unpaid work stoppage at the NGO, dealing with young kids at home, sleepless nights (thus, the name), closing on a new house, and returning to work with a 3-hour round-trip commute — just to name a few! All these occurrences and events led Sleepless to a lot of soul-searching about his/her best employment option. By best, I mean best for his/her mental health, his/her family’s happiness, and achieving Financial Independence (FI).

In many ways, what Sleepless conveyed to me was quintessential Great Resignation stuff. In other words, COVID-19 forced many people into reconsidering what’s essential in their lives. Many determined that returning to their previous jobs under pre-pandemic pay and conditions wasn’t worth it. Thus, a lot of Sleepless’ round three questions were geared towards determining which pensionable position (former or current) had the better pension plan, which job provided a faster way to the Financial Independence Retire Early (FIRE) lifestyle, and whether or not I could model the differences between the two pensions.

At one point, Sleepless even asked if keeping both pensions as annuities at age 55, which would pay out $1500 per month, was better than rolling them both over; or keeping one and cashing the other out. At another point, Sleepless seemed intent on moving back to the previous job to secure a better retirement healthcare plan. However, that changed when he/she learned about the added requirements needed to qualify for healthcare under the old pension system. Which is a long way of me saying the conversations ranged far and wide!

Questions? The Retirement Budget Is The Answer

While I answered some of Sleepless’ questions more generally, in reality most of them could only be answered by Sleepless. For example, there was zero chance I could accurately model the two pension scenarios for Sleepless to determine which one was better for achieving FI. I say that primarily because it required a level of intimacy and detail with Sleepless’ personal finances that he/she wasn’t willing to provide. However, even if I had those details, I still would’ve struggled with all the “what ifs?” I know this because I struggled to do the same thing for my pension situation in 2016, and I was more than intimate with all of my personal finance details!

Furthermore, and I can’t underscore this enough, questions like the $1500 per month one could only be answered after Sleepless had determined his/her family’s spending needs in retirement. And, Sleepless hadn’t done that yet. That’s not Sleepless’ fault. He/she had so much going on in his/her life that it just wasn’t a possibility. However, much like I wrote about in my book and have written about in other pension couch articles, a truly well-informed pension decision isn’t possible without retirement budget knowledge.

Life Questions

In my humble opinion, though, a lot of that misses the point. Most of Sleepless’ questions were life planning questions disguised as “run the numbers” questions. And, I was OK with that. After all, that’s what The Golden Albatross inflection point is all about. It’s the point where the mathematical numbers crash into the realities of life as people make decisions about their pensionable jobs. Often those decisions must be made with less than perfect data.

So, with that realization in mind, I circled around to the original question that started this multi-month exchange. What should Sleepless do with the former pension? And in this case, I was actually willing to provide advice. I did so because the answer wasn’t financial advice but life advice. I’ve provided our final exchange below.

The Final Exchange

Grumpus: Now that I know so much about your situation, I think that leaving the previous pension alone is the best move.

Sleepless: Until when do you think? Is there ever a point where rolling it out would make sense?

Grumpus: Until you make the decision to stay or go from the NGO job. Yes, there is a point where it makes sense to roll your pension over … from the mathematical point of view. That point is now. It’s stopped accruing interest and is now losing value to inflation. Even with the 5 percent interest charge that you’d have to pay to buy back into the pension system (assuming you roll it out), mathematically, you’re better off rolling out the money, investing it, and growing it faster than inflation.

However, based on what I now know about you and all the uncertainty in your life, the small return you could make by rolling it out and investing it [compared to leaving it alone] doesn’t seem worth the pain and trouble. Seems to me you have much bigger issues to consider and make decisions about.

Unless I’ve completely misread the type of person you are (and hey, this is FB messenger and not a face-to-face meeting, so that’s possible), it doesn’t strike me that you are the kind of person who optimizes all life decisions along with the most mathematically efficient use of your money.

I think in the FI world, there is a lot of potential “peer pressure” to make decisions that are the “most efficient.” However, we can’t always make the most efficient decisions that improve our lives by 1%. Don’t get me wrong, that really appeals to certain types of people. However, for most of us, life’s just too messy. Every decision we make can’t be ruled by the math of efficiency. And, I think your decision about your first pension is one of those moments. Given the amount of uncertainty about your future, it appears to me that preserving your decision space about returning to your previous state job is way more important than something that proves 2% more efficient in the use of your pension money.

So, if this were me, I’d keep the pension where it is for the next few years and see how the NGO job, and life in general, plays out. I would also write this decision down and list all the reasons and assumptions that led me to this decision. That way, when I looked back in five years, I wouldn’t be wondering why the hell I made such an inefficient money decision.

In the meantime, I’d use whatever small amount of spare time that I could find while working and parenting and concentrate on developing a realistic retirement budget. Is it going to be perfect? No, which is why I would plan on updating it every 6 to 12 months. However, once you get comfortable with how much you spend as a family and how that might change as you retire, it gets a lot easier to make these types of pension decisions.

Sleepless: OK, I really appreciate your thoughts. They [the former pension system] never gave me a clear answer about how much exactly it would cost to buyback. Is that ever a real consideration? I don’t know how much these things would cost. Do you have any idea based on your experience?

Grumpus: Buying years into a pension system (like I discussed in Pension Series 17) isn’t cheap. So, I can’t imagine that it’d be cheap for you after having cashed out the entire pension, either. That said, I’d need more details about how you can fund that buyback before telling you how hard or expensive it would be. For instance, could you fund the buyback from a 401K or IRA without incurring early withdrawal or tax penalties? The answer to that could make a huge difference and is one of the reasons I think you’re better off delaying the decision for now.

Sleepless: Also, is my $1500 projected per month at 55 really worth it as a fixed portion of income? It seems a lot of people leave this NGO in their 40s and roll their pensions over. But I just wondered if that makes any sense as a fixed portion if you have investments in the market anyway?

Grumpus: Again, only you can ultimately answer that question. However, many people pay a lot of money for insurance annuities to provide the same service your pension funds are providing. Your pension funds are almost guaranteed to be providing that service more efficiently than an insurance company since the costs are already built-in.

Sleepless: I’m going to read about the buyback. Thank you for your thoughts. They’ve given me much to think over! I’m probably going to wait a year, as you said, and roll it out. At that point, things will be more clear. I have been a fan of yours for years, and this conversation just nailed it. Enjoy the [New Zealand] sun, and thank you again!

Grumpus: You’re welcome! Feel free to tell all your pensionable worker friends about the website and book. It helps keep the lights on, so I can keep spreading the message.

Deep Thoughts: Pension Roll-Overs

Based on Sleepless’ final message to me, I was just going to end this post with “Nailed it, end of!” and mic drop. However, I wanted to reiterate a few points about pension roll-overs from this long exchange. First of all, if you’re in a potential pension roll-over scenario, remember the four general principles that I initially provided Sleepless. Let them guide you as you approach any pension lump-sum/roll-over decision.

That said, life gets messy. Just because the math says one thing, it doesn’t automatically override other planning factors. In the case of Sleepless, I provided the exact opposite advice than what the math suggested because I believed the other elements in his/her life were more important. In other words, Sleepless’ life question was disguised as a math question. However, remember to write your reasons down. That way, you have a record of why you made the decision.

Thirdly, don’t forget that a lot of the questions that Sleepless asked me would’ve been easier to answer if he/she already knew what the family’s retirement budget looked like. Yes, it’s time-consuming, but it’s worth it because it unlocks the ability to model and test various scenarios. If you don’t know where to start, check out my posts on tracking your money, determining your gap number, and testing your retirement budget.

Finally, I actually did nail that answer for Sleepless, didn’t I?

(Queue mic drop sound!)